A Tool for Profits

By Fleming Meeks

WHEN WE WEIGHED IN ON (ticker: ITW) last June, the outlook for the industrial economy was bleak. General Motors had just filed for bankruptcy protection, and analysts were braced for the worst. The worst for ITW, however, didn’t look so bad.

While earnings were expected to slip 56%, to $1.35 a share, free cash flow was expected to top $1 billion. We thought this broadly diversified industrial manufacturer was a good bet to come out of the economic turndown in better shape that it went in. The shares, then $35.85, looked like a bargain, especially given their fat 3.4% dividend yield.

Yesterday ITW’s shares closed at $46.94, up 31% since our June Alert, compared with a 26% gain for the Dow Jones Total Stock Market Index. The stock could rise to the mid- to high-$50s in a year. The dividend yield is a still robust 2.6%.

ITW is made up of 840 autonomous business units in 60 operating segments, including transportation, industrial packaging, food equipment, power systems and construction materials. The company has historically grown both organically and through acquisitions. Last year we noted that the company was able to buy healthy businesses for four-to-six times Ebitda for deals, compared with seven-to-ten times a couple of years earlier.

So far this year the company has acquired four businesses with $26 million in annual revenue. Management says its current deal pipeline will add $300 million-to-$500 million in annual revenue this year; that number could go significantly higher as the M&A environment improves. ITW operates in 57 countries, and about 60% of its revenue comes from outside of North America; acquisitions are likewise skewed to international markets.

To manage this far flung empire the company uses a relatively simple “80/20″ strategy. Each business unit focuses on the 20% of items that produce 80% of profits. Ditto for focusing on the top 20% of customers and suppliers. At the same time the company consistently culls its weakest businesses in order to devote more time and resources to the strongest.

In 2009 the company far outshone the estimates from last May, earning $947 million, or $1.93 a share on revenue of $13.9 billion. Free cash flow came in at $1.9 billion. This year EPS are expected to jump 42%, to $2.75, rising to a record $3.40 in 2011.

ITW’s broad range of businesses gives the company exposure to early-, mid- and late-cycle industries. So when sales start to turn up, it’s typically the beginning of a long trend. The company’s rolling three-month sales performance shows that business is indeed picking up. In the three months through February, sales were up 10% over the same period a year earlier. As sales rise, so too will operating profit margins, which fell to 10% last year from 14.6% in 2008 and 16.3% in 2007. Management expects margins to rebound to 13%-to-14% this year.

Fleming Meeks is executive editor of Barron’s and the founding editor of Barron’s Daily Stock Alert. He previously served as editor of SmartMoney, The Wall Street Journal Magazine, and assistant managing editor of Barron’s. Meeks began his career in journalism 25 years ago as a staff writer for Forbes. He holds a B.A. degree from Windham College.If you have comments or questions, please contact him at fleming.meeks@barrons.com

David Englander is a staff writer for the Barron’s Daily Stock Alert. He joined in 2008 as a reporter. Prior to Barron’s, he worked as a consultant, advising Fortune 500 companies on growth strategies and mergers and acquisitions. He has also worked as an independent equity analyst. Englander holds a B.A. from Amherst College, an M.B.A. from the University of Rochester and an M.F.A. from Columbia University.If you have comments or questions, please contact him at david.englander@barrons.com

Alexander Eule has been a staff writer for Barron’s Daily Stock Alert since 2010 and a reporter for Barrons.com since 2006. Prior to the Stock Alert, Eule wrote the site’s Barron’s Take and Weekday Trader features, offering frequent insights into individual stocks and the broad market. He holds a B.A. from Columbia College and an M.S. in Journalism from Columbia University.If you have comments or questions, please contact him at alexander.eule@barrons.com